Ideas for Intelligent Investing

Category Archives: 100 Ways to Beat the Market

I like to read through the back issues of Value Investor Insight as part of my search strategy. It is a good way to become familiar with a lot of different companies. There is also tons of solid investing wisdom to be had, as Whitney Tilson and his partners hand-pick the best modern practitioners of value investing in all its various forms.

One profile that recently caught my eye was that of Pacifica Capital which is run by Steve Leonard. Steve is a sharp guy who made a fortune in real estate by adroitly putting the lessons of Mr. Market to work in the real estate market. Then, in the late 90’s he formed a money management firm and built a strong performance record.

Steve is a focused value investor who concentrates his capital in stocks of good businesses with strong management. He is patient enough to buy them at attractive prices and then hold on as they appreciate, all of which brings me to the point of this article: patience.

Steve has a great quote on Pacifica’s website:

“With individual stocks, 10% of the time they’re cheap enough to buy, 10% of the time they’re expensive enough to sell, and the rest of the time you should just hold them if you own them and avoid them if you don’t.”

Sorry if this is not new information. But this series is about what it takes to beat the market – not being novel – and patience is about as fundamental to that objective as anything I can think of. All the great ones agree on this point and many are quick to point out that most investors – no matter how much they pay lip service to it – do not possess enough of it.

Buffett talks about investors inability to do nothing and just sit still. In distilling the essence of his investing discipline, he sings the praise of “lethargy, bordering on sloth.”

Why not double or triple your investment discipline (even if it cannot be measured with anything approaching precision)? Resolve to wait for the S&P 500 to be off by at least 20% before making a purchase. Or insist that a stock be on the new low list before loading up. Or wait for those magical times when the yield on normalized current earnings exceeds 15%. Or wait until your relatives or friends are asking if it would not be prudent to get completely out of the stock market, or – notwithstanding your esteem for the wisdom of the Mr. Market parable – you cannot help feeling a little queasy about your own equity holdings.

However you get there, limit your buying to the 10% of the time – per Steve Leonard – when stocks are really cheap. Otherwise, just sit still and prepare.

I have made the point in the past that, if you want to beat the market, you need to pick stocks of companies that have a higher mathematical expectancy than that of the S&P 500. Of course, this could come in many forms, for example, a higher earnings yield, better growth prospects, higher certainty in the company’s future prospects, or a cheaper stock price in relation to the business’s underlying assets.

To determine a stock’s mathematical expectancy, you need to do the math. For example, if you buy a stock that sells for a P/E of 30 and that you project to grow at 12% per year – something very few companies can do – for the next 10 years, what will your return be if it sells at a market-average multiple of 15 in year 10? It turns out that your return would only be about 4.5% – hardly mouthwatering! Moreover, you would have given yourself little or no margin of safety.

When he spoke at Columbia in 2010, Tom Russo explained how Buffett thought about Internet valuations during the tech bubble of the late 90’s. At the shareholder meeting, a questioner pressed Buffet on why he was not buying tech stocks such as Cisco. At the time, Cisco was earning about $1 billion annually and had a market cap of approximately $500 billion. Buffett started out by saying that the same $500 billion – Buffett often thinks in terms of buying the entire company – would earn $30 billion if invested in 10-year treasuries. Moreover, Buffett had some doubts whether the $1 billion in earnings was solid, given such items as options. So after year one, if you invested in Cisco, you would be in the hole for $29 billion in earnings. Take the analysis out two years and the earnings deficit would become much bigger still. Buffett doubted a person investing on these terms would ever catch up with the earnings forfeited by not simply buying treasuries.

There it is: simple math – no algebra, fancy spreadsheets, or Greek letters.

Next time you are looking at an investment, do the math. In fact, do the math on all your current holdings, if you have not already done so. Use common sense. Make reasonable assumptions. Consider what would happen if things do not go well. Build in a margin of safety.

It is not complicated, yet many do not have the discipline to do the basic blocking and tackling that makes all the difference. Resolve today to always “do the math”.

A couple weeks ago, my favorite college football team was playing in their big rivalry game. It was a close game that went back and forth. At the two minute mark, my team had the ball, trailing by three, with an opportunity to win the game, if they could execute their two-minute drill and score a touchdown. Unfortunately, they fell short, not just because they did not make plays, but also because they seemed confused and poorly prepared.

Knowledgeable football fans know that the key to an effective two-minute drill happens long before the actual game. It is all about preparation. There is little or no time to figure it out in real time when you have the pressure of trying to come from behind and win the game.

For me, this was yet another reminder that you need to be prepared ahead of time in the markets. You cannot wake up on the morning of a big down day in the market and expect to make good decisions on what to buy if you have not already done your homework.

These are the days when opportunity presents himself. Buffett recently said he was buying heavily on the big down days in August. Templeton would do his valuation work when the markets were calm and then put in his standing purchase orders at deeply discounted prices. Then he would wait.

You need a well conceived watchlist if you want to beat the market. Your watchlist does not need to be long. It needs to be thoughtful. Start with a short list of high conviction ideas that you truly understand. Determine an appropriate buy price by valuing the businesses on the list and selecting a reasonably discounted entry point.

These optimal opportunities do not come along everyday, but they do happen. If you are honest, you can probably recognize many sub-optimal purchases that you have made because you missed these types of opportunities and were willing to pay too high a price for at least some of your securities.

Resolve to correct these poor tendencies. Read my eBook on the investment process for more advise on improving your process. There are no short cuts or magic valuation algorithms. It is about sweating the details day in and day out. That is how consistent market-beating performance is earned.

One simple way to beat the market is to buy and hold Berkshire Hathaway stock at a good price. Buffett acknowledges that it is challenging to find intelligent ways to invest Berkshire’s massive and growing cash holdings. Nevertheless, he is clear that his goal is still to beat the S&P 500 which he believes he can do, albeit at a diminished level of outperformance vis-a-vis Berkshire’s earlier halcyon days. It is worth noting that Buffett is famously conservative in his missives about his ability to continue to outperform.

Berkshire’s recent performance compared to the S&P 500 is noteworthy. Berkshire has outperformed the S&P 500 in each of the ten most recent five-year periods by an average margin of just over 7%. For the record, Berkshire has never had a five-year period where it underperformed the market.

Buffett believes that Berkshire’s stock is undervalued at 1.1x book value (or approximately $109,000 per A share). He’s right. If you net out the equity investments ($67 billion as of Q3, 2011) and use Buffett’s estimate of normalized after-tax earnings ($12 billion), Berkshire has an earnings yield of about 10%. These earnings are being generated by a diversified portfolio of high-quality businesses that includes a number of bullet-proof, growing world-class franchises such as GEICO and BNSF.

Berkshire enjoys a number of advantages which should continue to increase its intrinsic value.

Berkshire has outstanding veteran managers who are unencumbered by bureaucracy or quarterly earnings numbers. They focus solely on building long-term value.

Berkshire can not only purchase operating businesses, but also marketable securities. This gives it a much higher likelihood of finding attractive investments compared to the typical S&P 500 corporation which is constrained to allocate capital within its own industry. Moreover, Berkshire has advantaged access to many deals based on Berkshire’s reputation, deep pockets, and ability to act quickly.

Berkshire has a shareholder-oriented culture. Board members (excluding Buffett) own over $3 billion in stock, and compensation is completely aligned with shareholder interests. Moreover, Berkshire is imbued with a culture of frugality. This means that Berkshire’s wealth will increase the value of shares rather than line the pockets of management.

Berkshire enjoys cheap leverage in the form of insurance float. Although it is impossible to predict with any amount of precision, it seems likely – based on Berkshire’s track record – that float will continue to grow. Berkshire can also borrow at low rates given its strength.

Buffett is still at the top of his game and getting better. The IBM purchase shows his savvy and growing circle of competence and, in my humble opinion, has a reasonable likelihood of adding $10 billion in value over the next 10 to 15 years. Todd Combs and Ted Weschler are warming up in the bull-pen and were hand picked by the same guy who spotted Lou Simpson.

Of course, not losing money should be top of mind when considering an investment. Berkshire has a fortress balance sheet with massive cash holdings as a hedge against economic disruption that puts Buffett in a position of strength to take advantage of opportunities when others are scrambling. Also, Berkshire’s commitment to repurchase shares below 1.1x book puts a floor under the stock.

The value of a business is the present value of all future cash flows that it will produce. Determining these future cash flows is the serious work of a securities analyst. Ratios that look at past and present performance often reveal little about a business’s future prospects. Thinking is required, and that can’t be automated or delegated.

Frequently, these future cash flows simply cannot be determined with precision. One risk that you must be on guard against is whether a business is subject to disruption. You need to consider what could kill the business? This is a foundational question, perhaps the most important.

If the business is generating a good return on capital – and these are the types of businesses you should be looking at – you can be certain that there are those who would love to storm the castle and steal the gold.

One of the biggest disruptors is the Internet. We all know that it’s a game changer for many businesses. Before making any investment, you need to think long and hard about whether your prospective investment is subject to Internet disruption and, if so, to what degree. It’s the difference between investing in businesses like Borders or Circuit City that were massively affected by the Internet and BNSF that is largely impervious to Internet disruption.

So how do you think about Internet disruption? A checklist is a good tool here. Make a list of the issues and factors you need to think about and then run it down when contemplating a purchase.

I just came across a good one in Bill Ackman’s analysis of Lowe’s. Ackman is considering the impact of online shopping on home centers such as Lowes and Home Depot.

If you want to beat the market, carefully and systematically think about how your investments could be disrupted. Use a checklist to capture the issues and then have the discipline to put your checklist into practice. You’ll be richer for it.

In his 1994 shareholder letter, Warren Buffett extols the phenomenal performance of Scott Fetzer: it earned an extraordinary return on equity without the benefit of a monopolistic position, leverage or strong cyclical tail winds. Scott Fetzer’s return on equity – had it been included in the 1993 Fortune 500 – would have earned it a number 4 ranking. Buffett attributes the company’s success to the managerial performance of Ralph Schey, Scott Fetzer’s CEO.

But here’s the somewhat surprising point. It’s not because of any managerial gymnastics on Schey’s point. It’s because – as Buffett points out – Schey handles the basics extraordinarily well and doesn’t allow himself to get diverted.

Schey, “Establishes the right goals and doesn’t allow himself to get diverted.”

Buffett explicitly points out that this approach applies not only to the management of a business, but also to investing. Extraordinary things are not necessary to get extraordinary results. Yet, the temptation remains to complicate things. We allow ourselves to be pulled in a million directions, even more so today because of the unlimited potential distractions that the Internet provides.

If you want to beat the market, keep it simple. Decide what your goals are. Put in place a rational process to achieve them and then work hard.

“Before the gates of excellence, the high gods have placed sweat.” – Hesiod

If you want to beat the market, you need to have a clear understanding of what drives market returns. Generally speaking, you can expect the returns of the the S&P 500 to be closely correlated with the growth of corporate earnings. Corporate earnings in turn are closely tied to GDP growth. After all, per Buffett, you can’t expect a component part – corporate earnings – to indefinitely grow at a faster rate than the aggregate to which they belong – the overall economy.

You can provide your own estimates, but assuming that real GDP growth averages 3% and that inflation is at 3%, your would get a 6% return. Add in 1.5% for dividends and you are 7.5%. If you are expecting more than this, then you need to provide and defend your assumptions.

Is the market’s return on equity closer to the high end or the low end of its historic average? Are multiples of earnings high of low? What are your expectations for interest rates going forward? These all play a roll in setting expectations.

What is the point of this exercise if you are trying to best the market?

In sports, top athletes carefully study their opponents so they can get an edge. If you clearly understand what drives overall stock market performance, you can make a rule for yourself that you will only buy securities that offer superior expected returns both as a function of the businesses’ underlying economics and also the price you are paying for their securities.

If you buy better businesses at better prices, you will beat the market.

Charlie Munger has said that one the most effective filters you can use to optimize the allocation of capital is to compare a prospective stock purchase to your best current holding. If it’s not as attractive, don’t buy it.

Instead, consider buying more of your best holding. This type of thinking will force you to move capital into optimal opportunities and will prevent the dillution of your efforts. Munger also points out that it is a powerful time saver. If your idea is not as good as your best holding, you can forgo wasting time doing any further research.

Another variant of this idea is to compare your idea to buying Coca-Cola. Coke is a great company: virtually unlimited growth prospects, Fort Knox balance sheet, unassailable franchise, low capital intensity, minimal regulatory and litigation risk, strong management, etc. Always remember that (most of the time) you could just buy Coke and your almost guaranteed of getting a good, if not spectacular, result. Run down your idea against Coke and honestly determine if it is worth it on a risk-adjusted basis. This may keep you from doing some dumb things with your precious capital.

Some years ago, George Leonard wrote a wonderful book called Mastery which gives wise advise on how to become highly skilled at something. The book has helped many people in numerous endeavors and continues to be widely read today. I contend that consistently beating the market requires a high level of skill and that one would be well served by paying attention to what Leonard has to say on the subject of mastery.

Leonard teaches that true mastery requires an understanding that learning a new skill comprises brief periods of progress punctuated by long, successively higher plateaus, and even this does not always happen in regular clockwork fashion. During these plateaus further progress seems elusive. Yet, even without being conscious of it, learning continues. Lessons are being assimilated and the mind and body are preparing for the progress necessary for reaching the next plateau.

The key is recognizing and accepting that this is the nature of pursuing mastery. And that learning to love the plateau is an essential requisite for getting where you want to go.

Leonard further explains that there are three opposing and deficient character types which thwart the pursuit of mastery and short-circuit its attainment: the dabbler, the obsessive and the hacker. The dabbler begins the pursuit of mastery and initially makes good progress. However, once the dabbler hits the first inevitable plateau, he loses interest and moves on to something else. The obsessive thrives on getting better and settles for nothing less than continual progress. To fuel this progress, he throws himself into the task at hand and presses hard – too hard. Eventually he becomes burnt out and moves on to something else. Finally, there is the hacker. After some initial progress, the hacker hits a plateau where he is content to stay, never spending the time or effort to grow and move on to greater levels of skill.

To beat the markets requires mastery. Learn to love the plateau by finding joy in doing the necessary work, confident that real progress will follow and true skill will develop in time.

When an average person goes to an accountant, they expect, and usually receive, value in exchange for payment. Likewise, when hiring a plumber, electrician, attorney or any number of other specialists, the average layperson receives reasonable value in the exchange.

When it comes to money managers, though, this may not be the case. There is a lot of data that shows that, as a group, money managers’ performance equals that of the general market minus the frictional costs they incur in the form of fees, commissions, slippage, and taxes. How could it be otherwise? Many savvy investors such Bogel, Buffett and Greenblatt advise that average investors simply invest in an index fund and pocket these frictional costs. This is certainly a rational approach, and, as long as expectations are kept in check, it is likely to generate a reasonable return over the long term. Also, it has the added benefit of minimizing, if not eliminating, self inflicted wounds.

What about going it alone as an active investor? I think Buffett is correct that a person who spends an hour or two a week on investing has the potential to get a significantly worse result than simply buying and holding an index fund, particularly if he is doing focused value investing. Being able to value a company is sine qua non for successful value investing and this requires time and experience. Without good valuations grounded in independent work, you will lack the necessary conviction to buy meaningful positions and hold them through the inevitable ups and downs of the market. You could also get seriously burned if you buy something that looks “cheap” that really is a lousy, deteriorating business.

So why do many investors – even those who call themselves value investors – continue to dabble?

First, speculating can be very exciting and enticing. People can go to great lengths to speculate, even if it means dressing it up as value investing. Second, because investing outcomes are a result of both luck and skill, it is easy to draw the wrong lessons from one time successes or bull markets that generate good results for everyone, even know-nothings. These misguided lessons can lead to the conclusion that it is easy to make money in the markets. This is closely related to over-confidence bias which continues to draw patsies into the markets even when they bring nothing to the table and can offer no sound reason why they should generate a sound return when trading against well informed, sophisticated counter-parties.

Therefore, if you want to beat the market, don’t dabble. Dedicate yourself to it in a serious fashion or find a professional with the right investing framework and psychological makeup who will. Short of that, you’re better off investing in an index fund.

The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures.
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